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Petrobras: new discoveries offer prospect of strategic changes

Petrobras has discovered important new light oil deposits that significantly increase its reserves and require less refining than most of its domestic deposits. The finds will improve the company´s portfolio and could lead to further important discoveries of light oil.

On April 21, to great fanfare, Brazils Luiz Inácio Lula da Silva, President at the time of going to press, found himself dressed in an orange boiler suit, on P-50, a platform in the Albacora Leste, located in the northern part of the giant Campos Basin. He was there to flip the switch to start the platforms operations. Later, Lula held up an oil smattered hand to the cameras in a gesture that echoed that of former President Getúlio Vargas who incorporated Petrobras as a state-owned company in 1953. For this was no ordinary platform: it was the one that would finally give Brazil the holy grail of every industrialised nation: self-sufficiency in petroleum. The story was trumpeted through the media with TV, radio and the net as a potent symbol of Brazils growing economic power and autonomy.

The income and profit statistics for Rio-headquartered Petrobras are staggering, even though oil prices have come off the boil since the spring. It is the biggest business in Brazil and in 2005 it was the 22nd most profitable company worldwide according to Fortune 500 magazine, placing it on the heels of Johnson & Johnson and ahead of companies like GlaxoSmithKline (26) and J.P. Morgan Chase & Co (29). It is the ninth largest company globally in the downstream sector (refining, transportation and trading) with eleven refineries, two fertilizer plants, depots, pipelines, terminals and ships.

In 2005, Petrobras ended the year with annual daily production of oil and gas of 2,217 million barrels of oil equivalent and consolidated earnings of R$23.7 billion ($11.1 billion). Last fiscal year, Petrobras boosted annual oil production in Brazil by 13% year-over-year and the firm continues to act as a near-monopoly supplier to the domestic market  it has 140 million Brazilian customers for petroleum and by-products.

The firm has not been standing still, either. Through acquisition and expansion, it has become the second-largest producer of oil in Argentina, has been the leader in natural gas in Bolivia, and the third-largest industrial company in Latin America. It is increasingly important in west Africa and the Gulf of Mexico and has been moving to exploit Brazils head start in renewable energy by becoming a global distributor of Brazilian ethanol.

Strategy
An unassailable position in the domestic consumer market and access to a rich seam of territorial oil has given Petrobras enviable stability compared to the many oil firms whose business is concentrated in the volatile Middle East or meddling Russia. In line with many of its competitors, Petrobras has been facing the not altogether unpleasant dilemma of where to invest its windfall profits. It has long had an impressive track record in the bread and butter of exploration and production (E&P) and has some areas of specialisation that make it a world leader. In 1994, it broke the world record for deep-water oil extraction by drilling over 1,000 meters below the surface of the ocean and it is now able to access oil that is trapped at more than 2,000 meters below.

Yet in refining and international diversification, Petrobras had suffered until recently from a reputation for being relatively slow. The last five years has seen the company start to come to grips with these areas. One of the prime difficulties has been that Brazilian oil deposits are primarily heavy while what its customers need are derivatives from light oil. Heavy oil requires an expensive refining process and Petrobras had been using third party refineries, losing a significant part of the value chain. The company is now buying and upgrading refineries to capture more of the entire process and make it a more vertically-integrated firm. It has also been moving aggressively abroad in a bid to give it a more diversified portfolio and to make use of its deep-water expertise. Finally, it is combining the two strategies by looking to find light oil overseas and by buying refineries abroad that are able to process heavy oil.

This has started to pay dividends, slowly. Petrobras is refining more of the heavy oil found in its own waters, increasing the amount from 1,292,000 barrels per day to 1,376,000 in 2005 year-over-year, although it saw an increase of just 1% in the total refined in Brazil, that is oil found both at home and brought from overseas. It has also started purchasing refineries overseas, including a 50% stake in a refining facility in Pasadena that will process 70,000 barrels on completion in four years. The firm is also interested in buying refineries in Asia.

David Zylbersztajn, ex-president of Brazils National Petroleum Agency and currently president of his own firm DZ Consulting in Rio de Janeiro, says that to remain a global player, Petrobras will have to continue to look overseas. The firm is seeking to increase its international activities with investment outside Brazil between 2004-2010 slated to be $7.5 billion of 15% of all the companys investments.

The company has been in west Africa since the late 1980s and has been increasing its presence in the Gulf of Mexico, both areas in which it has made reasonable recent discoveries. Their acquisition of a block in Angola was one of the most expensive ever but promises to be a rich seam. Zylbersztajn notes that Petrobras had a headstart in bidding because of strong relations between the Brazilian and Angolan governments and the common lusophone culture. Its difficult to say whether the companys strategy is to pay for the oil or the rights. Its possible that the deal was more to gain a foot-hold in Angola. When foreign companies were first allowed into Brazil, they paid a premium, he says. In May, Petrobras confirmed its most recent Angola foray, buying a 30% stake in a consortium that is spending $1.1 billion for the rights to explore deep-water deposits.

Emerson Leite, analyst at Credit Suisse in São Paulo, is more sceptical about the firms international expansion. He points to the untapped potential in Brazil. The moves to grow abroad absorb management time and diverts resources away from the core business, he says. And although the west African projects are making headway, some of the projects the company is looking at overseas are of questionable value, he believes. They are high risk, high return strategies, such as in Tanzania and the Caspian Sea, where the likelihood of a serious investment is low. Still, Emerson concedes, its very unlikely well see a retraction of the strategy. And for now, overseas businesses remain pretty piffling: Brazil continues to account for the lions share of Petrobras business with 90% of their upstream activity.

If the company is meeting with some success in west Africa, the international track record in its own backyard has recently been impaired. Usually, state ownership is an advantage in international negotiations. However, Petrobras is finding itself a victim of wider political trends. The fragile and deteriorating state of Latin Americas Mercosur and Brazils prickly relations with some of its neighbours have underlined this.

It must be frustrating for management, for example, that much of the local news on its international business has been focused on Bolivia, hardly a success story. That countrys President Evo Morales decided to nationalise the petroleum and gas industries. That has seen him take a series of unilateral decisions that culminated with the announcement on September 12, through Resolution 207/2006, to give Bolivian national oil company YPFB effective control over the cash flow of the Brazilian firms Bolivian arm, Petrobras Bolivia Refinacion (EBR). The resolution appears to create conditions for the Bolivian government to use excess profits of the company as a rebate for potential indemnification payment, according to Leite. More recently, the Bolivians have shown a willingness to negotiate as gas prices in international markets have dropped in line with petroleum, but the country remains committed to nationalisation.

And its not only in Bolivia that Petrobras is becoming unstuck. In Ecuador, protests against its presence in a national park have seen the government shelve the firms development plans. Operations in Venezuela have a mixed record and are unlikely to be a priority while Hugo Chavez is still in power and it has been difficult for Petrobras to build a more fruitful relationship with Mexicos PEMEX. The 2002 purchase of 58% of Argentinas Pérez Companc has upstream potential but its usefulness to Petrobras portfolio is questionable, says Emerson. Its a challenging asset to manage especially with the volatility of the country and the possibility of expropriation of foreign assets.

The other major strategy is to build refining capacity. Brazil has been a bottleneck in this respect, says Zylbersztajn. This is particularly true as Petrobras has been successful in finding new deposits of oil at home, increasing the quantity of heavy oil that it needs to refine. Refining is the Cinderella of the industry, often dismissed in the industry as a low margin business, and there was considerable scepticism when Petrobras unveiled its strategy to increase its profile in the sector.

Company managers have argued that making refining a priority is necessary to meet the growing demand for by-products. To get more out of its existing plants, Petrobras is adapting refineries to different types of oil. The firm has been working on a Strategic Technologies Development Program for Refining to transform low-value heavy residues into products that are in great demand on the Brazilian market, such as diesel fuel, gasoline and LPG.

Most of the activity is in Brazil where plans to develop the giant and controversial Rio-based petrochemical complex COMPERJ have been mired in planning and other difficulties. The construction of a basic unit is expected to cost $3.5 billion and will be carried out with Brazilian petrochemical group Ultra. Leite sees it as a challenging proposition and wonders if Petrobras is not over-paying for the resource which will absorb a large part of the planned downstream investments. Zylbersztajn argues that the investment will be spread over the 10 year life of the project and the investment is justified in aligning Petrobras product with its customers needs.

The Latest Finds
The obsession with converting refineries to manage heavy oil may be challenged by Petrobras most recent finds. The company confirmed on October 4 that it had discovered a significant volume of 30º API light oil in an exploratory frontier of the Santos Basin. Its early days yet and the company had made no announcement on just what significant means. Furthermore, it will be two years before the site can be evaluated and a further three years before any oil is likely to be extracted. Nevertheless, Petrobras hinted at the importance of its discovery by describing the reservoir as highly productive. The discovery followed another made on July 11. Both belong to a block operated by Petrobras (65%) in consortium with BG (25%) and Portugals Petrogal (10%).

The new find may mark a turning point in the refining strategy for Petrobras, believes São Paulo-based João Severiano, energy analyst at Link Corretora, one of the countrys top 10 equity brokers. First, the finds are in light oil, which requires less refining for use than heavy oil. Second, the finds could be as large at 750 million barrels. Thats against total proven reserves in the country of 9 billion barrels.

The discoveries could mean a shift in Petrobras policy of upgrading its refineries to convert heavy oil. The company started a project to upgrade its refineries to process more heavy oil three years ago, says Severiano. The firm will spend $23 billion of its $87 billion in planned investment over the next five years on downstream activities. Of that, $3.7 billion will be spent converting refineries to handle light oil and $2.7 billion will go towards adding new refinery capacity to convert heavy oil.

Any additional revenues from these recent finds could help develop other projects. One logical project would be the development of the gas fields in Santos Bay. This has become a political hot potato in the country because of severe delays and because gas has become big news because of the sensitivity surrounding Bolivias manoeuvrings. The project has faced delays and remains undeveloped. They keep on pushing back the date for opening up the field. Theyre now saying 2009, a lag of eight or nine years.

Theres a further intriguing possibility. There may be far more significant deposits of light oil in the Campos Basin underneath the salt crust, says Severiano. So far, Petrobras has only extracted oil from above this salt crust and this has been heavy oil. If Severianos hypothesis is right, the light oil finds discovered so far may be just the beginning. He cautions that it is not yet possible to know if these reserves do indeed exist and whether it would be economically viable to extract them. Petrobras declined to comment on the possibility.

If the new finds do turn out to be commercially viable and if what has been found to date is only a small part of the total field, Petrobras is likely to enjoy a much better mix of light and heavy oils in its portfolio and stronger revenues.